Why LUNA and UST Collapse?

Unless you've completely switched off from crypto, or the news cycle for that matter, you're probably aware of LUNA losing 99.99% of its value in a matter of days. Terra Protocol and its two main tokens - UST and LUNA - went into freefall as a carefully constructed mechanism (supposed) hit a snag. And a big one at that.

To understand what happened, it's important to understand UST and LUNA's correlation in the Terra ecosystem. UST is a stable coin; however, unlike USDT (Tether) or USDC, it's not backed by cash, short-term US govt. securities, commercial papers, etc. UST is an algorithmic stable coin - it maintains its peg to the USD through financial engineering. Or at least it used to.

How Does It Work?

Terra made use of an arbitrage function to maintain UST's peg. The protocol has two pools - a LUNA pool and a UST pool - and each can be traded with the other. The key: 1 UST can always be traded for $1 worth of LUNA.

So, if UST loses its peg and drops to, say, $0.99, traders can trade a large quantity of it for LUNA worth $1 each, thus earning a profit of $0.01 on every token. Traded UST is burned in the process, further reducing the supply and increasing its price to $1.

Conversely, if UST's value rises to, say, $1.01, traders can trade LUNA to create UST and earn a profit of $0.01 on every token. UST supply increases and the price drops to $1 again. Also, traded LUNA is burned in the process, making it more valuable.

Furthermore, to incentivize traders to burn LUNA and create UST, Terra offered a whopping 19.5% yield on UST staking through the Anchor Protocol. Prior to the crash, over 70% of UST's circulating supply was staked in this protocol.

The Luna Foundation Guard (LFG)

To protect the peg further, Terra founder Do Kwon created the LFG, a non-profit that held a reserve fund of around $3 billion in BTC and other cryptocurrencies. Its job was simple - if UST dipped well below $1, the LFG would use the reserves to buy tokens and restore its peg.

If UST rose, they would sell UST and bring it back to $1, with the profit being used to replenish their reserves.

So, What Happened?

The catalyst began on May 7-8 and cascaded into Monday, May 9 - over $2 billion worth of UST was unstaked from the Anchor Protocol and hundreds of millions were sold immediately.

This huge selling volume pushed UST's price to $0.91. Traders rushed to take advantage, trading $0.9 worth of UST for $1 worth of LUNA. However, there was a hitch - only $100 million worth of UST can be burned for LUNA per day.

Consequently, UST couldn't retain its peg, and investors flocked to sell their stock, driving the price further down. This had a knock-on effect on the whole ecosystem and LUNA was dumped into oblivion.

The LFG quickly exhausted its reserves trying to restore UST's peg but in vain. Over a billion in BTC was sold in the process, triggering a sell-off and affecting the entire market. Billions of dollars in crypto value were wiped out within a matter of days.

This event further highlights the key tenets of investing: do your own research, give weight to fundamental analysis, and only invest money that you can afford to lose.